What is a Liability?

Liabilities are like IOUs…

It’s money that a company owes and has promised to pay in the future, whether it be to a bank who lent them money or to employees who have worked for them. Companies use these IOUs in the course of their normal business operations.

When businesses spend money, they’re spending money they already have — or they’re borrowing. Borrowing might mean either taking out a loan or working with a vendor on credit, where the vendor provides goods or services, and the business pays them later. Liabilities are those financial obligations that haven’t been paid yet.

Liabilities are a vital part of a company’s financial picture. Like most consumers, businesses don’t necessarily pay for everything with cash on hand. Let’s say a consumer wants to buy a new house. The consumer is likely to take out a mortgage to purchase a home. Likewise, companies take out loans to expand their company with a new building or piece of equipment. Additionally, many consumers put their purchases throughout the month on a credit card and then pay the balance at the end of each month. Similarly, businesses hire vendors and employees who provide a good or service to them, and then the company pays them afterward.

Liabilities can be broken down into two primary categories:

1. Current or short-term liabilities
2. Long-term liabilities

Current or short-term liabilities are those that will be settled within 12 months of the company receiving the economic benefit. In other words, they are liabilities that belong to the current year. An example of a short-term liability would be accounts payable to specific vendors, or payroll to employees. Existing debts also include interest and monthly payments on long-term liabilities. For example, a 30-year mortgage wouldn’t be a current liability, but the monthly payments for the upcoming year would be.

Long-term liabilities are those that will not be settled within a year. Often these long-term liabilities will be loans that companies take out to expand their business. These liabilities might include things like debt for buying buildings and equipment.

Maybe you’re wondering about the relationship of liabilities to other financial terms such as assets, expenses, and revenue. Sure, they all relate to the money that a company has, doesn’t have, spends, doesn’t spend, etc. But how do they all work together?

Liabilities and assets appear together on a company’s balance sheet. The debts provide a summary of what the company owes. The assets offer an overview of what the company has. These assets might include money, as well as physical items such as buildings and equipment.

As we said earlier, one transaction could potentially represent both an asset and a liability on a balance sheet. If a company takes out a loan to purchase a piece of equipment, the money owed for the loan is a liability, but the machine is an asset.

The balance sheet that companies report their assets and liabilities on provides an overall view of the company’s financial situation. Public companies are required to file these updates every quarter. In addition to the assets and liabilities, the balance sheet also includes shareholder equity in the company. Financial analysts and prospective investors might use the balance sheet to learn more about the company’s finances.

The formula that describes the relationship between the assets, liabilities, and shareholder equity looks like this:

Assets - Liabilities = Shareholder Equity

Though they might sound similar, business liabilities and business expenses are not the same things. The liabilities are what the company owes, while the expenses are what the company spends. Payments encompass the money a company pays to do business. Money owed is found on a company’s balance sheet. Payments, on the other hand, can be found on a company’s income statement.

While assets and liabilities appear on a balance sheet in order to look at a company’s overall financial situation, the revenue and expenses appear on the income statement in order to determine the company’s profit.

The simple formula that describes the relationship between the revenue, expenses, and profit of a company looks like this:

Revenue - Expenses = Profit

Financial analysts and potential investors look at liabilities as one factor to consider when determining how a company is doing financially. There are a couple of different ways they do this.

First, analysts might look at the company’s debt-to-equity ratio. This ratio compares the liabilities on a company’s balance sheet to its equity (also found on the balance sheet). This ratio is determined by dividing a company’s debt by its total capital. For example, if a company has $50,000 in liabilities (or deficit) and $100,000 in equity, that company’s debt to equity ratio is 50%.

Companies in industries that require a lot of physical equipment might have higher debt-to income-ratios, but in general, a low debt-to-income ratio is a good goal to have.

The other thing that analysts may look at in a company’s financial picture is the debt-to-asset ratio. This ratio measures the liabilities of a company in relation to its assets. This number can be found by dividing the total liabilities by the total assets.

For example, if a company has $50,000 in liabilities (or debt) and $200,000 in assets, that company’s money owed to asset ratio is 25%. In general, the lower the debt-to-asset ratio, the better. Let’s say a company is going out of business. They should be able to use their assets in order to cover their liabilities, and hopefully, have money leftover afterward.

Financial analysts look at these liabilities to see how a company is doing. For example, business analysts would expect to see that companies have the cash on hand to cover all of their short-term liabilities and that their long-term liabilities are not higher than the assets they will earn in the future.

Liability is a broad term that simply refers to being responsible (aka liable) for something. So while it applies to the money a company owes that appears on their balance sheet, it is used in other areas of the business as well.

For example, if a customer sues a business for negligence, the company might be liable for damages owed to the customer. Imagine that a business has recently mopped its floor, and the ground is wet. A customer slips on the damp floor and suffers an injury that requires medical attention. The customer sues the business, and the company is found liable for the customer’s medical expenses.

In order to protect themselves from this type of situation, businesses often purchase liability insurance to protect them from loss in the event of a lawsuit.

Business liability insurance typically covers damages the company is liable for, as well as any legal fees the company incurs in a lawsuit.